September 25, 2021

Prudential and conduct of business regulation Prudential regulation is mainly concerned with consumer protection. It relates to the monitoring and supervision of financial institutions, with particular attention paid to asset quality and capital adequacy. The case for prudential regulation is that consumers are not in a position to judge the safety and soundness of financial institutions due to imperfect consumer information and agency problems associated with the nature of the intermediation business. Conduct of business regulation focuses on how banks and other financial institutions conduct their business. This kind of regulation relates to the information disclosure, fair business practices, competence, honesty and integrity of financial institutions and their employees. Overall, it focuses on establishing rules and guidelines to reduce the likelihood that: Consumers receive bad advice (possible agency problem); Supplying institutions become insolvent before contracts mature; Contracts turn out to be different from what the customer was anticipating; Fraud and misrepresentation takes place; Employees of financial intermediaries and financial advisors act incompetently. Licensing Edwin G. West (1997), freedom of entry is the most important condition of competition. Competition brings with it market discipline. However in most countries entry into the financial sector requires specific authority from a licensing authority. The power to grant licenses or similar entry authorizations provides the possibility of exercising preventive action against the entry of institutions whose presence might be prejudicial to the interests of depositors and the soundness of the system. Specific entry requirements are designed to strengthen the authorities control on the soundness of institutions allowed to conduct banking business, this could have an indirect impact on the structure of banking sector by limiting the scope of market entry. From a regulatory viewpoint, licensing aids the adoption of the principle that a bank must be effectively managed by at least two persons of proven expertise, competence and trustworthiness. The rationale behind the adoption of this principle (the four eyes principle) is to ensure a certain depth of management and to provide for better internal control on compliance with banking laws and regulations’. In essence whereas licensing increases transaction costs, it also serves to cushion the entire economy against entry of investors whose integrity is questionable. There is a moral for licensing because deposits can be misappropriated easily; runs in one bank affects other banks and the economy. Besides since deposits are insured by government agencies there is need to keep off undesirable owners. Reserve requirements Reserve requirements force banks to hold a portion of their assets in a liquid form easily mobilised to meet sudden deposit outflows. Bernanke (1983) indicates that the bank runs of 1930-1933 in US led to large withdrawals of deposits, precautionary increases in reserve deposit ratios and an increased desire by banks for liquid or rediscount able assets. These factors plus the actual failures forced a contraction of the banking system’s role in the intermediation of credit’. Banks are in intermediation service and high reserves can harm the process. Diamond et al (1986) argue that 100% reserve requirement would restrict banks from transformation services. The effect of this would divide the bank into two. The proposal would then effectively pass the problem of runs and instability to the successors in the intermediary business. The policy would reduce the overall amount of liquidity. Reserve requirements are a back up to deposits. In case of a bank run, a bank experiencing temporary liquidity problem could use the reserves to solve the shock. Besides if the regulatory authority discovered that the bank was fatally illiquid then the reserves could be used to pay off depositors before DI is used. Capital requirements Bank capital is the equity that the bank shareholders acquire when they buy the banks stocks and since it equals the portion of the banks assets that is not owed to depositors it gives the bank an extra margin of safety in case some of its other assets go bad. Bank regulators set minimum required level of bank capital to reduce system’s vulnerability to failure.  

Lender of last resort facility (LLR) Banks can borrow from the Federal Reserve’s/ Central Banks discount window. While discounting is a tool of monetary management, the 1 Fed/CBK can also use discounting to prevent bank panics. When the Fed acts this way, it is acting as the lender of last resort to the bank. When depositors know the Fed is standing by as the LLR they have more confidence in the bank’s ability to withstand a panic and are therefore less likely to withdraw if financial trouble is looming. When crisis prevention fails Central Bank as LLR has an obligation to deal with the consequences at minimum cost. Central Banks intervention must be decisive. Owners and managers must incur substantial losses. Besides, the Central Bank should not unnecessarily be drawn into LLR financing of banks and exposure to major credit risks. Only in a systemic case should the Central Bank deal with the crisis. Where the Central Bank directly or indirectly funds pay outs through deposit insurance the issue of limiting monetisation arises. Bagehot 1873 classic, in a crisis the lender of last resort should lend freely, at a penalty rate on good collateral. Meltzer (1986) argues that insolvent financial institutions should be sold at market price or liquidated if there are no bids for the firm. The losses to be borne by owners of equity, subordinated debentures, uninsured depositors and the deposit insurance fund. The discount window should be opened only in times of systematic failure, but be freely available to all institutions that are creditworthy and who provide substantial amounts of liquidity insurance. Deposit insurance, moral hazard and adverse selection Deposit insurance is a guarantee that all or part of the amount deposited by savers ina bank will be paid in the event that a bank fails. The guarantee may be either explicitly given in law or regulation, offered privately without government backing or may be inferred implicitly from the verbal promises and/or past actions of the authorities. In recent years, many nations have adopted or are considering a system of explicit or formal deposit insurance. Deposit insurance may encourage bankers to make risky loans because depositors no longer have reason to withdraw their funds from carelessly managed banks. Therefore deposit insurance presents the danger that bad business judgements will distort the market. Ricki Tigert Helfer (1999) argues that anything that encourages risky behavior by leading financial risk takers to believe that they will reap the benefits of risky investment they make while being protected from the losses is a moral hazard. Diaz Alejandro 1985 argues that like any other insurance scheme, deposit insurance is vulnerable to moral hazard consequences i.e. it induces depositors to think that onebank is as good as another and leads bank managers to undertake riskier loans. This follows from Maxwell Fry (1995).A bank accepts deposits at competitively determined terms that are set before the bank makes its project choices. The bank then has an incentive to invest in projects if riskier projects carry higher repayment obligations from entrepreneurs to the bank. This is asset substitution moral hazard. Under deposit insurance there is a balancing act, assure financial stability when liquidity and solvency problems arise but at the same time minimizing moral hazard. To limit moral hazard, the market place should be allowed to discipline financial risk takers by letting insolvent institutions to fail. Those that come close to failing should pay hefty costs; this could be in the form of high interest costs on short-term liquidity support. In general insolvent banks should be left to fail and shareholders lose their equity. In the case of too big to fail, countries have to save institutions to ward off systemic problems. As Ricki Tigert Helfer indicates a reasonable balance between moral hazard and a stable financial system would permit a very limited exception for failures that pose a systemic risk, while letting the market discipline improvident behavior. The too big to fail doctrine imposes moral hazard on the investors. They no longer have the responsibility to investigate the soundness of the institutions in which they deposit their funds. The doctrine is immoral. It segregates the industry. The big banks can afford to take considerable risk/moral hazard incentives whereas the small banks are constrained. Besides it accords an unfair competitive advantage over small banks apart from reducing depositor incentive to police their banks. It also conflicts with the tenets of a discipline encouraging market friendly DI as outlined by Garcia and Carl-Johan Lindgren (1996).

BANK REGULATION AND SUPERVISION The rationale for regulation Financial systems are prone to periods of instability. In recent years, a number of financial crises around the world (South-east Asia, Latin America and Russia, Global financial crisis) have brought about a large number of bank failures. Some argue that this suggests a case for more effective regulation and supervision. Others attribute many of these crises to the failure of regulation. Advocates of the so-called ‘free banking’ argue that the financial sector would work better without regulation, supervision and central banking. In the absence of government regulation, they argue, banks would have greater incentives to prevent failures. However, the financial services industry is a politically sensitive one and largely relies on public confidence. Because of the nature of their activities (illiquid assets and short-term liabilities), banks are more prone to troubles than other firms. Further, because of the interconnectedness of banks, the failure of one institution can immediately affect others. This is known as bank contagion and may lead to bank runs . Banking systems are vulnerable to systemic risk , which is the risk that problems in one bank will spread through the whole sector. Bank runs occur when a large number of depositors, fearing that their bank is unsound and about to fail, try to withdraw their savings within a short period of time. A bank run starts when the public begins to suspect that a bank may become insolvent. This creates a problem because banks want to keep only a small fraction of deposits in cash; they lend out the majority of deposits to borrowers or use the funds to purchase other interest-bearing assets. When a bank is faced with a sudden increase in withdrawals, it needs to increase its liquidity to meet depositors’ demands. Bank reserves may not be sufficient to cover the withdrawals and banks may be forced to sell their assets. Banks assets (loans) are highly illiquid in the absence of a secondary market and if banks have financial difficulties they may be forced to sell loans at a loss (known as ‘fire-sale’ prices in the United States) in order to obtain liquidity. However, excessive losses made on such loan sales can make the bank insolvent and bring about bank failure. Bank loans are highly illiquid because of information asymmetries: it is very difficult for a potential buyer to evaluate customer-specific information on the basis of which the loan was agreed. The very nature of banks’ contracts can turn an illiquidity problem (lack of short-term cash) into insolvency (where a bank is unable to meet its obligations – or to put this differently – when the value of its assets is less than its liabilities).Regulation is needed to ensure consumers’ confidence in the financial sector. According to Llewellyn (1999) the main reasons for financial sector regulation are: To ensure systemic stability; To provide smaller, retail clients with protection; and To protect consumers against monopolistic exploitation. Systemic stability is one of the main reasons for regulation, as the social costs of bank failure are greater than the private costs. The second concern is with consumer protection. In financial markets ‘ caveat emptor’ (‘Let the buyer beware’) is not considered adequate, as financial contracts are often complex and opaque. The costs of acquiring information are high, particularly for small, retail customers. Consumer protection is a particularly sensitive issue if customers face the loss of their life time savings. Finally, regulation serves the purpose of protecting consumers against the abuse of monopoly power in product pricing. The most common objectives of Bank regulation are: 1. Prudential: To reduce the level of risk bank creditors are exposed to (i.e. to protect depositors) 2. Systemic risk reduction: to reduce the risk of disruption resulting from adverse trading conditions for banks causing multiple or major bank failures 3. Avoid misuse of banks: to reduce the risk of banks being used for criminal purposes, e.g. laundering the proceeds of crime 4. To protect banking confidentiality 5. Credit allocation :to direct credit to favored sectors Types of regulation Systemic regulation; Prudential regulation; Conduct of business regulation. Systemic regulation Charles Goodhart et al. (1998) define systemic regulation as regulation concerned mainly with the safety and soundness of the financial system. Under this heading we refer to all public policy regulation designed to minimize the risk of bank runs that goes under the name of the government safety net . In particular, this safety net encompasses two main features – deposit insurance arrangements and the lender of-last-resort function.

Financial Intermediaries and Information Costs Information costs make direct finance expensive and thus difficult to obtain. This generates the role of indirect financing and financial intermediation. Much of the information collected by intermediaries is used to reduce information costs and the effects of adverse selection and moral hazard. To reduce adverse selection, potential borrowers are typically carefully screened. To minimum moral hazard, all borrowers are carefully monitored and the penalties are imposed on borrowers who violate their financial obligation. Banks reduce information costs in the following ways: Screening and Certifying to Reduce Adverse Selection Before getting any type of loan, a potential borrower must fill out an application. Typically this application will require information, like a social security number, which can be used to gather your credit history and credit score. This credit score tells a lender how likely you are to repay a loan. The higher the score the more likely you are to pay back the loan. Once this information is verified, a borrower with a higher credit score will have access to larger and/or lower interest rates. Banks also use other types of information beyond your loan application. Many banks look at patterns in your checking or debit card accounts. They can learn a gr eat deal about your habits and gauge certain types of risks for the bank. Banks gathered tons of information, have specialist who can interpret this information, and can effectively minimize adverse selection problems. Monitoring to Reduce Moral Hazard To minimize moral hazard problems, banks also use specialists to monitor individuals who take out loans and firms who issue stocks and/or bonds. Many times the bank will actually take part in the same investment strategy of the borrowing firm, (or use a venture capital firm to do the same thing). In this way the bank can more closely monitor the activities of the firm and monitor where it is that they use their borrowed funds. Finally it should be noted that the market system itself can help to limit moral hazard problems. If a firm is mismanaged and the stock price falls, a new company can take-over and remove the managers. Because of this, it is generally in the interest of the managers to satisfy the desires of the stockholders of their company.\  

INFORMATION ASYMMETRIES AND INFORMATION COSTS Information is a central element to efficient markets. When the costs of obtaining information are too high, some potentially beneficial transactions do not take place and markets tend to stall. Information costs sometimes make financial markets the worst functioning markets. In most all transactions, the issuer of a financial instruments, borrowers, know some information which the buyer, saver, does not know. This is a situation know as asymmetric information. There are two information problems which form obstacles to smooth running financial markets. The first problem is called adverse s election . This problem arises before the transaction ever occurs. Simple fact is that lenders need to know how to differentiate between good risks and bad risks. Unfortunately for them, that is information only the borrower has. The second type of information problem is called moral hazard . This problem occurs after the transaction has taken place. Lenders need to find a way to tell whether borrowers will use the proceeds of a loan as they claim they will. We should look at some examples, their details and implications of these problems and their implications. Adverse Selection One of the best documented situations in study of asymmetric information is the Lemon’s Problem. This problem was revealed by 2001 Nobel Prize winner in Economics George Akerlof in his analysis of markets with asymmetric information. His contribution came from a 1970 paper titled “The Market for Lemons” in which he explained why the market for used cars, some of which are “lemons”, does not function well. Suppose two cars are for sale, both of the same make and model. One is in good shape and was owned by a previous owner who maintained a good maintance record and drove very little. The second car was owned by someone who sparingly changed the oil and loved to drive in the fast lane. The owners of the cars know whether their own car is in good repair, but the buyer does not. Let’s say the potential buyer is will to pay $15,000 for a well-maintained car and $7,500 for a lemon. The first car owner knows the car is in good shape and won’t sell it for less than( $12,500. The other owner knows that the car is in poor shape and would be willing to sell for as little as $6,000. Without knowing anything else about the car, the risk-neutral buyer would only be willing to pay the expected, average, price for these cars wh ich would be $11,250. That is less than the first owner is willing to sell for, thus the only car we can buy is the lemon. In this type of world no one with an above average car would ever put their car on the market. Thus, the market is full of lemons. Due to this asymmetric information, Several entities exist that help solve this problem. Consumer reports can be established about the sellers of used cars. Many people now offer warranties on used cars and buyers can use mechanics to help verify the true state of the car. As a result we should find the prices for good and bad used vehicles closer to their true value. When it comes to financial markets, this adverse selection problem exists just as it exists with used cars. Potential borrowers know more about the projects they wish to finance than potential lenders. In the same way that adverse selection can drive out the good cars this situation can drive good stocks and bonds out of the financial market. For instance, two firms, one with good prospects and one with bad prospects, as a potential stock buyer, since you cannot tell which firm is which, you would only be willing to pay the average stock price as a risk neutral investor. The stock of the good company would be undervalued. Since managers of this company know that their stock would be undervalued, they would never bother issuing it in the first place. That leaves only the firm with bad prospects in the market. This would be known by investors and the market would have a hard time getting started. The same thing can happen in the bond market. Risk requires compensation and if you cannot tell the high risk bonds from the low risk bonds, the lender will demand the average premium on all bonds. This drives companies with good credit out of the market unwilling to pay the inflated interest rate. Since lender are not interested in buying debt from bad companies, the market would not function. Solving the Adverse Selection Problem The adverse selection problem creates situations where good companies will pass on potentially valuable investments. Since these investments are lost, the best companies are not necessarily the ones that grow as rapidly as they should. At the same time, poorer companies may take on investments which they should not be doing. So, it is important to identify the good companies from the bad companies. There are two basic methods for solving problems of adverse selection: Create more information for the investors Disclosure of Information the most straightforward solution to adverse selection Since it creates more information. This can be done by government regulation or through other market forces. Most publicly traded companies are required to release a lot of information through requirements set up by the Securities and exchange regulatory authorities. Public companies are also required to release information which can influence the wealth of the company and any information that is given to professional stock analysts. The newly created accounting regulations are geared at closing these loop holes through which firms may be able to hide the true financial position of a firm. Guarantees Another way of solving this problem is providing guarantees in the form of contracts that can be written such that the owners of the firms face the same risks as the investors. The contract is written in such a way that lenders are compensated even if the borrower

FINANCIAL INTERMEDIATION The efficiency of an economy is much determined by not only how developed the financial system is but also by the effectives of its financial intermediation. A health economy requires a well run intermediation process. A financial intermediary is a firm whose assets and liabilities are mainly financial instruments. The goal of financial intermediation is to pool resources from savers and lend them to people and firms who need to borrow. These institutions also play a pivotal economic function of gathering and relaying information about the financial conditions of firms and individuals which helps in allocation of resources to their most valued use. The failure of intermediation process implies the fall of financial sector and this can cripple the whole economy for instance the failure of the banking sector in the 1930s helped to bring about the Great Depression. Similar arguments exist for the Asian crisis of the late 1990s. The Role of Financial Intermediaries Financial intermediaries perform five basic functions which are crucial in the economy These functions are listed below: 1. Pooling of resources from small savers 2. Providing safekeeping and services and access to the payments system 3. Supplying liquidity 4. Providing methods and avenues of diversification to reduce risk 5. Collecting and processing information to reduce information costs A keen observation reveals that the first four functions focus on reducing transactions costs while the fifth function deals with reducing information costs. An in-depth analysis of the three functions is given below:  Pooling Savings The most obvious function of a financial intermediary is to pool resources of a large number of small savers. By pooling these resources the banks can then make large loans to other people or firms. It is very unlikely that one person could finance a $200,000 mortgage or a multi-million dollar investment. However, a bank will pool together the asset of several individuals to accomplish this goal. To be effective, financial intermediaries need to attract a large number of savers. This is generally accomplished by banks who make savers feel secure in the fact that their assets are safe.  Safekeeping, Payments System Access, and Accounting Banks used to construct large, heavy safes which looked imposing. This safekeeping of valuables and assets is just one of several services provided by intermediaries. Banks provide services that give savers quick access to their assets through things like ATMs, credit and debt card, checks, and monthly statements. Bank are extreme efficient at financial transactions greatly reducing their costs. Many banks also provide bookkeeping and accounting services. They help customers maintain their finances and plan for the future. Providing Liquidity Financial intermediaries also provide liquidity to their customers. Liquidity is simply the ease at which assets can be turned into a means of payments and thus consumption. Banks allow their depositors to quickly and easily turn their deposits into money quickly and easily whenever needed. Borrowers also benefit from easier liquidity. They can make loans which require repayment in a extended fashion. Intermediaries specialize their balance sheet so that they can make sizeable quick withdraws for customers. Diversifying Risk Banks mitigate several types of risk. First, they take deposits from many people and make thousands of loans with these deposits. Thus, each depositor faces only a small amount of the risk associated with loans that would go default. No one depositor losses all their assets when a bank loan goes unpaid. Banks also provide a low-cost way for depositors to diversify their investments. Mutual fund companies offer small investors a way to purchase a diversified portfolio of several different stocks. Collecting and Processing Information One of the biggest problems that savers face is whom to lend their assets too. The fact is that the borrowers could lie about their true state and the lender has little ability to verify the truth. Finding out the truth can be a costly venture. The problem of information asymmetry sets in i.e the borrowers have information that the lenders do not. By collecting and processing information, financial intermediaries reduce the problems associated with asymmetric information. Loan applicants are carefully screened. They monitor loans for timely payments hence reducing this information problems. These information problems have huge implications on the financial systems.